Blackstone's Tony James Discusses the Need for Pension Plans to Increase Returns Through Greater Allocations to Alternative Investments

The following is an edited version of Tony James’ remarks on Blackstone’s recent 2Q earnings call on the need for pension plans to increase their allocations to alternative investments

With interest rates in the largest economies around the world that are negative in real terms, and equity markets that are anemic and volatile, investors have never needed alternative investment products more than they do today. If our nation is going to be able to provide for its future, pension funds and other institutional investors must earn more than they can get in public markets. And they must do so on a scale large enough to move the return materially on hundreds of billions of dollars. I believe that only alternative investments can fill this need. Indeed, I don't think the US pension system can come close to being solvent without having major investments in alternative assets.

Investors are not going to hit their return hurdles relying on bonds. If they put money in investment-grade debt or government bonds, they earn 2%. But the returns they must earn across the portfolio to fund their obligations are 7.5% to 8%. They certainly are not going to get that by putting a whole lot of their money into government bonds at 2%. Such investments help provide safety and liquidity, but actually put them even further behind their requirements on return.

I believe pension systems are also not going to get where they need to be with public equities. As an economy, we are going to be looking at slower real growth than we are used to. In the last 40 years we have had a leveraging up cycle which artificially inflated real growth in our economy, and now, and I think for quite a while, we're going to have a deleveraging cycle that will retard real growth. If so, the public stock market will have a hard time returning more than mid-single digit returns, call it 5% to 6%. So if a fund has most of its money in bonds and stocks with returns ranging between 2% and 6%, and it has to get to 8% to be solvent, the only way it can do that is to put a sizable chunk of its portfolio in alternatives that can earn double digit returns.

That is the role we play for institutions, and it is a service they must have. I don't think it's a choice. On the one hand, voters are not going to be enthusiastic about higher taxes. On the other, it would be really unfair to pensioners, who have worked all their lives with the expectation they'd have a certain pension, to take that away from them when they're at an age where they can't replace the income, don't have the savings and can't work anymore.

This puts our whole pension system in a horrible bind. As a society the only viable way to get out of this mess is to earn more on the portfolios. Alternatives allow pensions to do this and allow them to do so with consistency and with confidence. The only real negative of alternatives is lack of liquidity. But pension plans in general have more than enough liquidity. They own plenty of tradeable bonds and plenty of public stocks. There is not a need to have instant access to vast amounts of liquidity in any pension system. It is predictable when people age and what they are entitled to receive in distributions. Most institutions over-invest in liquidity, and they pay a significant penalty in their returns for doing so.

I think most of them will come to realize that alternatives are really their only viable solution.